As the Federal Reserve begins a two-day meeting to determine monetary policy, there are signs cropping up that the markets are confused about what Chairman Ben Bernanke and company are saying – or unconvinced that they will follow through with their promises.
For the past six months, the Fed has pursued a simple strategy, consisting of two promises of future action. The first is an open-ended commitment to purchase $85 billion in bonds each month until the economy improves. The second is a guarantee to keep short-term interest rates near zero until the unemployment rate is under 6.5 percent.
The second part of that strategy is what Fed watchers call the “Evans Rule,” adopted by the Fed in December and named after Chicago Fed President Charles Evans, who had campaigned for the Fed to tie its monetary policy to a specific employment goal.
The idea was for the Fed to send a simple, clear message to the markets: monetary conditions would not be tightened until some kind of a real economic recovery was in place. Part of the purpose of the Evans Rule is to remove uncertainty about the Fed’s actions from the long list of things businesses have to worry about.
With the Evans Rule in place for half a year now, there are limited signs that it has worked as intended. The economy has added an average of nearly 200,000 jobs in the past six months, despite the mix of tax hikes and spending cuts that took effect in the resolution of the fiscal cliff and sequestration. The S&P 500 and Dow Jones Industrial Average also have seen significant gains over the same period.
The Fed’s success, to the extent it has been successful, is attributable to the simplicity of its approach.
Nevertheless, as the Fed’s June meeting approached, there have been indications that the markets are getting confused about what the Fed is doing.
In particular, data released by the Labor Department Tuesday shows that inflation has remained low, barely edging above zero to 0.1 percent in May after a negative reading in April. Over the past month, long-term inflation expectations have trended downward, according to the Cleveland Fed.
In a column for the Financial Times on Sunday, the hedge fund manager and Fed observer Gavyn Davies wrote that bond yields now indicate that the market expects the Fed to raise short-term rates in mid-2014, rather than in 2015 as the Fed’s unemployment rate projections imply would be consistent with the Evans Rule.
Are these market indicators are out of step with the Fed’s plans?
Some commentators have suggested that the markets have made no mistake, and that the Fed is set to begin slowing its asset purchases, or “tapering” down from $85 billion in Treasury and mortgage purchases each month. Bernanke indicated in a congressional hearing last month that such a slowdown might come soon, saying that he could slow the pace of purchases “in the next few meetings.”
The stock markets fell from a record high the day before Bernanke’s comments, indicating a sense that the Fed would announce an eventual end to the bond buys at this month’s meeting.
The Financial Times’s Fed reporter Robin Harding reported Monday that a move toward tapering is indeed what Bernanke has planned for the meeting, suggesting that the Fed might be satisfied with monthly job growth of around 200,000 because it has become “less optimistic” about potential employment growth.
Other Fed analysts, however, are not convinced that the markets have it right, and expect the Fed to recommit to quantitative easing and re-emphasize its commitment to near-zero interest rates. Jon Hilsenrath, the Wall Street Journal reporter generally thought to have the best sources within the Fed, wrote last week that Bernanke “seems likely to press that point at his press conference.” In other words, Bernanke will explain that the bond purchases won’t slow down soon and that rate increases are still years away.
Bernanke will try to clear up confusion over the Fed’s policies Wednesday, when he is due to announce the outcome of the Federal Open Market Committee meeting and takes questions from the media.